Global Demand for Dollars Is Not Influenced by Fees
In a previous piece, I addressed the notion that tax cuts inevitably lead to higher interest rates and consequently, trade deficits. But what about the following discussion? Does a larger deficit result in a stronger dollar, which in turn means a widening trade gap? That connection doesn’t really hold up either.
Even if interest rates increase due to tax cuts, the next aspect of Furman’s argument presupposes that higher tax rates will automatically strengthen the dollar. Here’s the issue: Dollars do not change value in a uniform manner.
Economist Stephen Milan noted, before he became the head of the Trump administration’s Economic Advisory Council, that a strong global demand for dollar-denominated assets continues to elevate the dollar’s value, consequently reducing competition for exports and making imports cheaper. In simpler terms, the strength or weakness of the dollar is mostly determined by the global appetite for dollar savings, rather than interest rates.
Next is economist Michael Pettis’s perspective. He presents the challenge in a similar light, arguing that US trade deficits are influenced by global capital movements, not by domestic budgetary policies. Nations like Germany, China, and Japan boast current account surpluses and need to invest their excess savings, with the United States offering the safest capital market available. This influx of capital strengthens the dollar but diminishes US exports, not due to local tax policies but because of foreign commerce.
According to Pettis, the trade deficit represents the cost the US incurs for providing a stable location for foreign investments. Additionally, fiscal deficits often arise from a lack of demand resulting from trade imbalances—this flips Furman’s narrative: Trade deficits drive fiscal deficits, rather than the reverse.
At the very least, exchange rates are influenced by numerous competing factors, and financial expansion will likely introduce as many negative influences as positive ones on the dollar. Furthermore, a rising deficit may lead to potential inflation and expectations of financial easing, raising questions about fiscal sustainability. If investors perceive the US as a less disciplined borrower, they may move their portfolios away from dollar assets. Under these circumstances, the dollar might weaken, actually narrowing the trade deficit by making US goods more appealing abroad.
A 2008 study by Soyon Kim, an economics professor at Seoul National University, and former IMF economist Noriel Lubini found that depreciation of actual exchange rates creates a pattern referred to as “twin divergence,” where budget deficits increase while trade deficits decrease. This contradicts Furman’s predictions and demonstrates a discrepancy evident throughout decades of US economic history. Essentially, the real economy does not always adhere to the Feldstein chain; sometimes, it diverges.
The Fallacy of Tax Cuts Encouraging Import Growth
Furman also claims that tax cuts will escalate the trade deficit by increasing the money Americans spend on foreign goods—like German cars, Chinese electronics, and imported beer. This could link to the “twin deficit” theory, dubbed Furman Chain. However, this only holds if tax cuts truly result in a surge in product consumption. In reality, a significant portion of the US economy leans toward services, as does most consumer spending.
When individuals receive tax cuts, they don’t necessarily rush out to purchase foreign-made items. Instead, they manage expenses like rent, food, healthcare, and other domestic services. In fact, services comprise over two-thirds of US consumption, with most of these services being non-imported.
This viewpoint is supported by research from Michele Cavallo of the Federal Government of San Francisco, showing that a 1% increase in GDP linked to government spending only marginally worsens checking accounts by about 0.15%. Why is this the case? Because much of that spending does not directly lead to imports but disperses unevenly throughout the economy, focusing on sectors like housing, healthcare, and education.
Additionally, one must consider that Trump has increased tariffs on imported goods. This could dampen demand for imports and potentially drive up prices of foreign products, making it even less likely for tax cuts to increase import expenditures.
Thus, it is misleading to suggest that tax cuts will encourage shopping for foreign goods. A significant portion of the increased demand may actually land in the domestic services sector, reducing the link between tax cuts and the trade deficit.
What Does This Mean for Trump’s Tax Cuts?
This doesn’t mean we should ignore deficits, but Fullman’s assertion—that Trump’s tax policy will lead to both larger budget deficits and a greater trade deficit—relies on a model that doesn’t stand up to scrutiny.
Tax cuts do not automatically reduce private investments. They don’t always fortify the dollar, and they certainly don’t guarantee a worsening trade balance. As noted previously, the relationship between budget deficits and trade deficits is often weak and may fluctuate, sometimes even moving in opposite directions.
